A tax break is lost, another is found

By Jesse Drucker,

On either side of a two-lane road, and surrounded by the lush green mountains of Villalba in central Puerto Rico, stand a pair of manufacturing plants owned by Medtronic, the world’s biggest maker of heart-rhythm devices.

Medtronic does more than half of its $16 billion in annual sales of pacemakers, defibrillators and other devices in the United States. It manufactures the equipment at this facility, legacy of a defunct U.S. tax break designed to encourage investment on the poverty-stricken island. Yet, Medtronic credits the income to a mailbox in the Cayman Islands.

This isn’t what Congress had in mind when it did away with the federal tax credit for companies’ Puerto Rican profits. The break was attacked by Republicans and Democrats as too expensive, and, as of 2006, it ended. So Medtronic and other companies found a solution: They avoid taxes by moving those profits into shell subsidiaries in havens such as the Cayman Islands, Switzerland and the Netherlands.

“By aggressively shifting income to offshore affiliates, companies appear to be getting U.S. tax benefits that are equal to or greater than the ones they did under the old Puerto Rico tax break,” said Stephen E. Shay, former deputy assistant secretary for international tax affairs at the U.S. Treasury and now a Harvard Law School professor. “That almost certainly was not the intent of the repeal.”

The profits that used to benefit from the Puerto Rico credit are now part of a mountain of tax-deferred offshore earnings totaling at least $1.38 trillion, according to a May report by J.P. Morgan Chase. Companies including Apple, Google, Microsoft and Pfizer are lobbying Congress for a tax holiday to bring those profits home. Without such a break, any cash brought back to the United States would be taxed at the federal income-tax rate of 35 percent, with a credit for foreign income taxes already paid.

Medtronic, based in Minneapolis, paid income taxes in fiscal 2011 at a rate of less than half that — 16.8 percent. That’s also about half Medtronic’s rate under the old Puerto Rico tax credit.

As the Obama administration and congressional Democrats take aim at tax breaks for everything from corporate jets to private-equity manager compensation, the aftermath of the Puerto Rico credit’s repeal shows just how difficult ending such breaks can be — and how determined well-funded tax planners and their corporate clients are to create new ones.

‘Extraordinary’ profit

Now the IRS wants to collect some of those lost taxes. It has identified as a top audit priority the sophisticated strategies U.S. companies used to shift income that once benefited from the old tax break in Puerto Rico.

In a memo sent to IRS auditors in February 2007, the agency called profit levels “extraordinary” in many of the offshore units created to take over for the subsidiaries that got the Puerto Rican break. In many cases, those units are generating “an inordinate amount of the profits, i.e., amounts in excess of what would be expected, based upon activity,” according to the IRS memo.

The agency is in a $958 million fight with Medtronic in U.S. Tax Court over how it reorganized its Puerto Rican operations, as well as a $452 million court dispute with Guidant, now a part of medical device maker Boston Scientific, over a similar move.

Companies legally move profits offshore using “transfer pricing,” the system of allocating income between units in different countries. This lets corporations such as Medtronic say that profit from a $5,000 pacemaker was earned in the Cayman Islands, even though the device was manufactured in Puerto Rico and sold in, say, Houston. The company has accumulated $14.9 billion in income allocated to its foreign subsidiaries on which it hasn’t paid any U.S. income tax, according to its most recent annual report.

The profit shifting that can stem from transfer pricing costs the U.S. government an estimated $90 billion a year, according to Kimberly Clausing, an economics professor at Reed College in Portland, Ore. That’s about double the Department of Homeland Security’s annual budget and dwarfs the revenue loss from the various tax breaks under scrutiny. By comparison, changing the carried-interest provision that allows private-equity managers to pay taxes at a rate of 15 percent on most of their compensation would raise only about $2 billion a year for the federal government, according to the Joint Committee on Taxation.

Under U.S. transfer-pricing rules, offshore subsidiaries that license rights from their parent companies are supposed to pay an “arm’s length” price, or what an unrelated company would pay. Such transactions often involve the transfer of intellectual-property rights and other intangibles, for which real-world comparisons can be difficult to find. The IRS objects when offshore subsidiaries pay their parent company a price that the agency claims is too low, which shifts taxable profit out of the United States.

“We are confident that Medtronic has met the requirement in establishing arm’s-length pricing on all intercompany transactions,” said Amy von Walter, a spokeswoman for the company. She declined to comment on specifics of the IRS dispute.

Medtronic says in court papers that its offshore unit paid the correct amount for rights moved out of the United States.

The story of the Puerto Rico tax credit and its aftermath illustrates the cat-and-mouse game that companies and the U.S. government play when Congress tries to close tax breaks. In this case, even bipartisan support did not stop companies from quickly finding a new legal way to avoid paying taxes.

“It is a cautionary tale,” said Greg Ballentine, an economist with Charles River Associates, a consulting firm that advises companies on transfer pricing. “There is a very active and aggressive community of tax advisers out there, and they respond to whatever changes are made, congressional or regulatory. So the IRS is frequently several steps behind.”

Puerto Rico became a haven for the manufacturing operations of U.S. companies in the 1960s, when the government used tax incentives to combat poverty and unemployment on the island, which now has about 4 million residents.

In 1976, Congress added a tax credit that effectively exempted from federal income taxes the profits that U.S. companies attributed to Puerto Rico. The combination of the break, proximity to the United States and plentiful industrial sites prompted multinational companies to flock to the island, with medical-device and pharmaceutical makers leading the way, including Pfizer, Eli Lilly and Merck.

Companies separately negotiated tax holidays from the Puerto Rican government to be largely exempt from the island’s equivalent of a national corporate income tax, often paying at rates in the low- to mid-single digits.

By the mid-1990s, critics led by Rep. Bill Archer (R-Tex.), then the chairman of the House Ways and Means Committee, attacked the break as too expensive, costing the United States about $3 billion a year. In some industries, the tax subsidy was costing the United States as much as $72,000 per job, according to a study by the federal agency now called the Government Accountability Office. After a lobbying battle in 1996, the tax break was repealed, with a 10-year transition period for companies already benefiting from the credit.

“It pulled the rug from under our feet,” said William Riefkohl of the Puerto Rico Manufacturers Association.

Archer, now a lobbyist for accounting firm Pricewaterhouse­Coopers, which represents multinationals on tax issues, said, “We were determined to let everybody know we were going to close corporate tax loopholes that clearly stood out as being appropriate for repeal.”

The Joint Committee on Taxation projected that eliminating the break would raise close to $11 billion for the Treasury over the next decade.

“There was certainly an expectation the companies would react” after the repeal, said Daniel M. Berman, a deputy international tax counsel at the Treasury during the dispute over the tax break.

Berman was right. After losing the legislative fight, the tax-avoidance industry of accountants and lawyers sprung into action. While manufacturing facilities stayed in Puerto Rico, dozens of companies shifted the ownership of those assets to newly created subsidiaries in tax havens around the world.

Guidant, the medical-device maker once part of Eli Lilly and now owned by Boston Scientific, transferred assets formerly owned by its Puerto Rico subsidiary to a unit in the Netherlands, records show. Guidant says in its Tax Court filings that no taxes were due on the transfer of assets overseas and that intracompany royalties were priced properly. A spokeswoman for Boston Scientific, the second-biggest heart device maker, did not reply to requests for comment.

One leading strategist behind the new tax maneuvers was Ernest Aud Jr., a veteran international tax lawyer for accounting firm Ernst & Young in Chicago. Aud advised U.S. multinationals on how to turn the potential tax jam into an asset.

“I was probably the architect of a number of the early conversions,” said Aud, now retired from Ernst & Young. “We were the ones that made companies aware that there was an opportunity — underscore ‘opportunity’ — to maybe do better under” the new arrangement than under the old Puerto Rico break.

Grand Cayman subsidiary

Among those seizing that opportunity was Medtronic. The corporation has grown from a medical repair shop founded by a Minneapolis engineer in his garage into the world’s biggest maker of heart-rhythm equipment. It makes an array of other devices, including spinal technologies and insulin-delivery systems.

Dozens of pharmaceutical and medical-device makers that flocked to Puerto Rico, attracted by the various tax benefits. Medtronic opened its first factory in 1974 and expanded twice after that.

In August 2001 — about four years before the tax credit would disappear for good — Medtronic established a subsidiary in Grand Cayman, listing an address at an office now used by Intertrust Group, a corporate-services provider that helps firms establish shell subsidiaries in tax havens.

On paper, Medtronic transferred ownership of its Puerto Rican assets to this new Cayman unit, called Medtronic Puerto Rico Operations. The Cayman subsidiary is owned by a Dutch arm, which is in turn owned by a Swiss subsidiary, court filings show. In 2006, Medtronic transferred some of the Dutch company’s assets to the unit in Zug, Switzerland, a popular destination for companies seeking Swiss tax holidays.

The Cayman entity also entered into an arrangement to pay royalties to the U.S. parent to use intellectual property and other rights covering devices it manufactures in Puerto Rico and then sells back into the United States. The IRS contends that Medtronic’s Cayman unit underpaid for those rights, court papers show, shifting offshore income from U.S. sales. Taxes on such offshore profits are typically deferred indefinitely until the companies bring the earnings back to the United States.

Medtronic’s tax rate has plummeted. In 1995, the year before congress abolished the Puerto Rico credit, the break cut 4.2 percentage points off the company’s effective tax rate, helping to lower it to 33.5 percent. By 2011, Medtronic’s tax rate was down to half that. Overall, the savings from the low-taxed overseas income boosted Medtronic’s net income in fiscal 2011 by 30 percent, to $3.1 billion, based on tax disclosures in the company’s most recent annual report.

The company has benefited from a “tax incentive grant” in Puerto Rico, according to the annual report, but does not disclose that rate. Owning its Puerto Rican assets through a Cayman shell company lets Medtronic move cash around the world without being subject to a Puerto Rican withholding tax, according to two people familiar with such structures.

As Shay put it, “The government underestimated how sophisticated and aggressive multinationals would be in shifting truckloads of profits out of the U.S.”